Herbalife Pyramid Scheme Claims Investigated

Herbalife uses a network of distributors to sell its nutritional supplements and weight-loss products. (netodarkis/Flickr)

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Hedge fund manager Bill Ackman has won a round in his 15-month fight against supplements and weight-loss products maker Herbalife. The direct seller’s shares tumbled Wednesday after Herbalife revealed that it is being investigated by the Federal Trade Commission for possible “deceptive practices.”

Since December 2012 Ackman has spent millions waging a public campaign against Herbalife and building up an army of lobbyists, community organizers and members of Congress to push regulators to investigate what he calls a “pyramid scheme,” that makes most of its money by recruiting new salespeople rather than on the products they sell. It is a charge that Herbalife has repeatedly denied.

Ackman, the head of Pershing Square Capital Management, holds a whopping $1 billion “short” position in Herbalife, meaning he’s bet that the company’s stock will drop and profits when it does. While short sellers are sometimes demonized for profiting at another’s financial pain, they can play an important role in discovering problems with companies.

So far Ackman’s campaign has had mixed success. The SEC began conducting its own investigation into Herbalife shortly after Ackman’s initial accusations, but so far it hasn’t led to any enforcement action. He sparred publicly with Carl Icahn, who owns 17 percent of Herbalife through his firm Icahn Associates, with Icahn calling Ackman a “crybaby” on television.

Icahn has defended Herbalife and increased his stake in the company in recent months to back up his comments. The stock, which was hit hard at the outset of Ackman’s crusade, more than recovered, doubling to an all-time high of $83.51 at the beginning of this year.

Herbalife, which is incorporated in the Cayman Islands and based in Los Angeles, uses a network of distributors to sell its nutritional supplements and weight-loss products. Other companies, such as Amway, cosmetics companies Avon and Mary Kay and kitchen products maker Tupperware, use a similar network of independent contractors who market merchandise through demonstrations and other personal contacts.

Many people looking for extra income are attracted to becoming direct sellers because there are no large upfront fees. Startup kits range from a few dollars to several hundred dollars, according to the website of the Direct Selling Association, a national trade group based in Washington. There were nearly 15.9 million people involved in direct selling in 2012, and their sales rose nearly 6 percent to $31.6 billion that year, the most recent data available from the trade group.

The nutritional supplement and weight loss product maker Herbalife has seen its stock tumble 15 percent after the news yesterday that the company is under investigation by the Federal Trade Commission. The investigation comes after a 15-month campaign by hedge fund billionaire William Ackman, who had made a $1 billion bet on the collapse of the Herbalife stock in December 2012.

Joining us to talk about this is Derek Thompson, senior editor at The Atlantic. Derek, welcome back.

DEREK THOMPSON: Thank you, Jeremy.

HOBSON: And I guess we should start by just saying what Herbalife is.

THOMPSON: Herbalife is a 30-year-old company that sells weight loss shakes, vitamins, other stuff. It's listed on the New York Stock Exchange, but you might not have heard of it. And if you haven't heard of Herbalife, it might be because it doesn't sell its products in stores. It sells them through people like you and me who act as distributors. We sign up to buy the products, and we say we'll sell them to friends and peers and people in the neighborhood. Businesses call this multilevel marketing. You and I might call it the Avon lady model of business. And Bill Ackman calls it a Ponzi scheme.

HOBSON: Well, OK. Tell us why he thinks that it is such a sham?

THOMPSON: Right. This is a little complicated, but I'll try to make it as simple as possible. There's nothing wrong with the Avon lady model of business so long as there are people opening up the doors and buying the product. Herbalife says it recruits people to distribute its weight loss shakes to real, breathing customers. And it might well be right, it's a very big, very profitable company.

But Ackman, this hedge fund manager, after an exhaustive investigation of the company concluded that it was lying, that it didn't have enough customers to possibly justify its revenue, and instead that it hunts for gullible people to buy all these weight loss shakes from the company that they can't sell, they get stuck with it with thousands of dollars worth of products they can't sell. And so what the company does, Herbalife, it just moves to another city and does the same trick again. That's Ackman's accusation.

HOBSON: And Ackman, as we said, has made a billion-dollar bet against this company. And it's a company that has been invested in buy the other billionaire, Carl Icahn. The two of them got in a fight on CNBC in January of 2013. Let's listen to a little bit of that.

(SOUNDBITE OF TV SHOW, "FAST MONEY HALFTIME REPORT")

CARL ICAHN: I never said that I want to be friends with you, Bill. I wouldn't be friends with you...

BILL ACKMAN: OK, OK, Carl. OK. OK, Carl.

ICAHN: And I wouldn't - you said to me you'd like to be friends so that we could invest together.

ACKMAN: Carl, I have no interest. You think I want to invest with you? OK, let's move on.

ICAHN: I wouldn't do business with you if you were the last man on Earth.

ACKMAN: Let's move on. Let's move on.

HOBSON: Derek, it seems like Bill's getting his way now, Bill Ackman.

THOMPSON: What he's done is really interesting. He has basically launched after this $1 billion short - this $1 billion bet against the company - launched an incredibly public campaign to get anybody from the federal government, state governments, attorney generals to investigate Herbalife to prove that his bet was right.

There's nothing new about lobbying Congress to make money for your product or your interest. This is what tax loopholes are about - the Exxon, the housing industry. But it's really rather crazy the brazen openness of lobbying that he's doing right now in order to justify this extremely public $1 billion bet that he made against the company that hasn't in the last year gone its way before the recent announcement of the investigation.

HOBSON: So when do we find out what happens?

THOMPSON: I have no idea what's going to happen. It's very strange, I think, that they're having such trouble finding people who have been screwed over essentially by Herbalife. You would think that if there were all - if it was a true Ponzi scheme, and there were all of these suckers out there, it would be pretty easy to find them. But we haven't. That being said, on Wall Street perception is reality. And the perception that all these people are zeroing in on Herbalife trying to look into its practices is making Herbalife's investors nervous. And that's why you're seeing the stock begin to plummet.